29 May 2013

Risk.net: Economic woes and regulation add to VA hedging challenge

This article claims that with benign market and economic conditions still appearing to be a long way off, it is likely that consumer demand for VAs will remain high. Turning this demand into a profit is very much a challenge of running effective hedging programmes.

Variable annuities (VAs) have always posed challenges, both to those that issue them and to the regulators that oversee the market. Insurers must design and hedge the products in such a way that they can meet their long-term liabilities. Regulators must assess whether the products – and the promises they make in terms of their in-built guarantees – present a risk to the overall financial system.

The guarantees in VAs, which can come in many forms but basically guarantee the performance of the underlying funds or their eventual payout, are in effect written put options. As such VA hedging programmes are essentially about hedging the sensitivities (greeks) of these options to market and economic parameters, most notably movements in the price of the underlying assets (delta), the volatility of the price of the assets (vega), the rate of change in the delta (gamma) and change in interest rates (rho).

Since the financial crisis, hedging programmes have become more sophisticated, with more realistic models and more dynamic approaches in terms of the frequency of the risk analysis and hedge trades. However, the overall approach to VA hedging depends to some degree on a company's attitude to the VA market. A number of insurers, particularly in the US, have decided that VAs are more trouble than they are worth and have either cut back or pulled out of the business. However, unless they sell off their books, they – like the companies still issuing such products – must still hedge their exposures.

Most VA hedging programmes today cover delta and rho, according to industry observers. The degree to which delta is hedged in the fund or on the balance sheet can depend on market conditions, with companies generally keeping more delta within the fund during times of unstable markets. The degree to which rho is hedged in the fund or on the balance sheet tends to come down to a company's view as to where it should best manage interest rate risk and differs widely from company to company. De-risked funds largely hedge vega internally.

Another focus of VA hedging programmes is credit risk. Here too, the issues are becoming more complex than was previously the case because the market has moved to using Libor to an overnight index swap (OIS) curve to discount the collateral attached to derivatives deals. Also, as regulators push OTC derivatives trading towards centralised clearing, collateral costs and complexity become more significant. The challenges of credit risk hedging in today's environment add to the requirement for more sophisticated modelling capabilities.

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